U.S. Treasury Market Goes Off Script

September 22, 2014

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The crosscurrents roiling the bond market intensified
Thursday, as the gap between short- and long-term U.S. Treasury yields narrowed
in the latest sign of uncertainty over the pace of U.S. growth. Yields on
short-term U.S. Treasury debt maturing in two to five years hit the highest
level since 2011, reflecting an investor scramble to place bets on an expected
Federal Reserve rate increase as soon as next spring. Yields rise when prices
fall.

The selloff in short-term government debt extended a
pullback that began following Wednesday's Federal Reserve decision to end its
bond purchases later this year. At the same time, yields on government debt
maturing in 10 or more years have risen only modestly this week and remain well
below their levels at the start of 2014, a year that many analysts forecast
would include rising long-term interest rates and falling bond prices.

The softness of longer-term yields highlights concerns
shared by many analysts and policy makers about the uneven growth of the U.S.
economy and falling expectations for inflation. Investors broadly expect the
Fed to raise the fed funds rate next year for the first time since 2006. But
many analysts say that even a small uptick in rates could slow the economy and
send already-low inflation further below the Fed's target.

Rising short-term rates typically are accompanied by higher
long-term rates in a robustly growing economy. The recent shift of U.S. short-
and long-term yields underscores uncertainty over the outlook. Low inflation
for a sustained period could raise fears of deflation, a damaging cycle in
which falling prices discourage consumers and businesses from spending.

The bond-market conundrum came as stock investors continued
to applaud the Fed's steady-as-she-goes message. The Dow Jones Industrial Average
gained 109.14 points to 17265.99 and the S&P 500 index rose 9.79 points to
2011.36. The Nasdaq Composite Index added 31.24 points to 4593.43.

In late-afternoon trading, the two-year note was 1/32 lower,
yielding 0.569%. The yield settled at the highest level since May 2011.

Yields on shorter-dated notes are sensitive to changes in
the Fed's interest-rate outlook, while yields on longer-dated bonds are more
influenced by inflation.

Thursday's upbeat labor-market report further added to
anxiety. Initial claims for unemployment benefits posted the largest drop in
nearly two years. Trading volume on derivatives betting on the Fed's
interest-rate outlook has hit a record high.

Another attraction to buying long-term U.S. bonds is they
offer superior yields compared with government bonds in Germany and Japan.
Traders said this will continue to draw foreign investors seeking relative
value. A rising dollar adds to the allure of buying U.S. bonds.